There are lots of news stories about the Federal Reserve Bank’s decision to begin raising interest rates, and many of them may create more confusion than clarity, especially when the stories try to explain what the rate hike means for consumers.
On March 16 the Fed raised the federal funds rate by 25 basis points—that is, a quarter of a percentage point. The Fed is expected to increase that rate at each of its next six meetings this year, to about 1.9 percent by the end of the year.
News stories often quickly shift from reporting the rate increase to discussions of how that affects other interest rates.
The confusion I hear from many people is wondering whether raising the fed funds rate directly affects the interest rates they are currently paying on such items as a home mortgage, car loan or even credit card debt.
The short answer is an increase in the fed funds rate typically won’t directly affect most existing consumer loans—but it likely will affect future loans.
Here’s the backstory. Banks are required to keep a certain percentage of their deposits in an account with the Federal Reserve Bank. If they run short of that reserve amount, they can borrow overnight from another bank that has excess reserves. The interest rate charged by that lending bank is the federal funds rate.
The Fed doesn’t force banks to lend to each other at that rate; rather it’s a target rate. The actual rate banks charge each other is negotiated. In its March 16 announcement, the Fed recommended a target rate of between .25 and .50 percent. The Fed is likely to increase that recommended rate at its next meeting in May.
While the fed funds rate increase won’t affect most people’s current interest rates, it will affect the “prime rate,” which is the rate commercial banks charge their most creditworthy borrowers.
The prime rate is generally about three percentage points higher than the fed funds rate, so an increase in the fed funds rate generally means an increase in the prime rate, which means an even bigger increase for most borrowers.
The Fed’s goal in raising the fed funds rate is to slow down the economy. Higher interest rates mean higher costs for businesses and individuals, which mean less business investment and consumer spending.
The challenge is to slow the economy just enough to lower inflation while avoiding a recession. Not everyone is sure this Fed us up to the task.